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Market Lab Report - Part 5 - The Six Essential Rules of Short-Selling (or for those who dont short, how to identify prone patterns for a safe exit)

Published:

11 Aug 2017 13:24 ET

Part 5 – The Six Essential Rules of Short-Selling

By Gil Morales, Managing Director, MoKa Investors, LLC

The last two rules among the Six Essential Rules of Short-Selling cover two important consideration in any trade: cutting losses and taking profits. The first, Rule #5, relates to the setting of stop-losses, the point at which you will cover a short position to cut a loss short. The second, Rule #6 discusses covers the less precise business of setting profit objectives in order to determine when to cover a short position so you can book that precious profit. In this segment, we will look at the first of these two rules.

‘Rule #5: Set stop-losses at an average of 3-5%, using the tighter 3% stop if the stock begins to rally against you on strong, above-average volume. A “layering” technique can also be used by “peeling off” and covering portions of the position as the stock rallies against you at a series of specified percentage thresholds, such as covering 1/3rd at 3%, another 1/3rd at 5%, and the final 1/3rd at 7%, or any other permutations. Stops are dependent upon personal psychological preference and risk tolerance, so short-sellers should try to determine what works best for them in real-time.

Speaking for myself, I like to use nearby reference points such as moving averages to set my stops. Since I will generally look to short a stock near a moving average such as the 20-day exponential moving average or the 50-day moving average. Relying on strict percentages isn’t something that I favor, as I like to “feel” how a stock acts around a moving average.

If it feels soft, I might give it 2-3% beyond a moving average, but if it feels like there is a strong bid underneath the stock, I may cover right at the moving average. Sometimes I might even flip out of my short position and go long the stock as it cruises through the moving average, but that is a topic for another time! For now, we have discussed Wyckoff undercut & rally formations which are buyable especially after market corrections.

But if I had to pin a specific percentage on what I would consider to be “allowable” losses on short positions, I would say that stop-losses on short positions should range around 3-5%, at most. A lot of this still depends on how strongly the stock is rallying against you, however. If you are down 3% on a position and the stock is trading above-average volume as it rallies from your short-sale point, it is best to implement the 3% threshold for your stop-loss with the idea that the stock can always be re-shorted if the rally suddenly fizzles out.

There is also another way to set stops, which I will implement from time to time. That is that I won’t let a short position turn into more than a 1% loss to my overall portfolio. So, if the stock is down an amount equal to 1% of my total account value, it’s fourth down and time to punt.

Stops on short positions are still dependent on one’s position size, personal psychology, and risk tolerance. Above all, keep in mind the basic reality that there is no “magic” stop-loss point that guarantees you won’t be whip-sawed out of a position, only to see the stock roll over and head lower again. Ultimately, where one sets their stop is primarily a function of how much money they are willing to lose if the trade does not work out and they are stopped out.

Portions of this article have been excerpted from “Short-Selling with the O’Neil Disciples: Turn to the Dark Side of Trading” by Gil Morales & Chris Kacher, published by John Wiley & Sons in April 2014.

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